Tuesday, March 31, 2009

The Center on Budget and Policy Priorities says that, contrary to what you
may have heard, the Obama budget "would reduce federal deficits by about $900
billion over the next ten years compared to current budget policies." Note also
that, relative to their "realistic baseline," the deficit is larger in the
immediate short-run than the baseline projection (but by enough?), and smaller in the longer run
(any truly long-run solution to the budget problem will require us to reform health care and reduce escalating costs):

Some critics charge that Obama’s budget is fiscally irresponsible, and they
cite CBO’s estimate that, under it, deficits would total $9.3 trillion over the
next decade. They fail to note, however, that these future deficits result from
the existing budget policies that Obama inherited — not those that he is
proposing. Ironically, some of these same critics supported the large tax cuts
and spending increases of recent years that helped convert the surpluses of the
late 1990s into the record deficits that we face today and in the coming
decades.

In fact, deficits would be $900 billion higher over the next decade
under current policies than in Obama’s budget. That’s because, in the budget
plan that he released in late February, the President includes a package of
spending and tax proposals that reduce future deficits by that amount.

Yochai Benkler discusses the use of the "assumption of
universal rationality and a sub-assumption that what that rationality tries to
do is maximize returns to the self" as a primary analytical foundation for our
models of sociological, political, and economic behavior:

The
End of Universal Rationality, The Edge: The big question I ask myself is how
we start to think much more methodically about human sharing, about the
relationship between human interest and human morality and human society. The
main moment at which I think you could see the end of an era was when Alan
Greenspan testified before the House committee and said, "My predictions about
self-interest were wrong. I relied for 40 years on self-interest to work its way
up, and it was wrong." For those of us like me who have been working on the
Internet for years, it was very clear you couldn't encounter free software and
you couldn't encounter Wikipedia and you couldn't encounter all of the wealth of
cultural materials that people create and exchange, and the valuable actual
software that people create, without an understanding that something much more
complex is happening than the dominant ideology of the last 40 years or so. But
you could if you weren't looking there, because we were used in the industrial
system to think in these terms.

A lot of what I was spending my time on in the 90s and the
2000s was to understand why it is that these phenomena on the Net are not
ephemeral. Why they're real. But I think in the process of understanding that, I
had to go back and ask, where are we really in between this what's-in-it-for-me
versus the great altruists and the stories of Stahanovich and the self-sacrifice
for the community?

Both of them are false. But the question is, how do we begin to build a new set
of stories that will let us understand both? The stories are actually relatively
easy. How we build actual, tractable analysis that allows us to convert what in
some sense we all know, that some of us are selfish and some of us aren't. That
actually most of us are more selfish some of the time and less selfish other of
the time and in different relations. That we don't all align according to the
standard economic model of selfish rationality, but that we're also not saints.
Mother Teresa wouldn't be Mother Teresa if everybody were like her.

So this is the puzzle that I'm really trying to chew on now,
which is how we move from knowing this intuitively and having a folk wisdom
about it to something that probably won't in any immediate future have the
tractability and precision of mainstream economics. Not, by the way, that as we
sit here today, mainstream economics necessarily enjoys the high status that it
might have a few years ago, but nonetheless so that we will be able to start
building systems in the same way that we thought about building organizational
systems around compensation, like options that ties the incentives of the
employees to that of the business, like we thought with regard to political
science that's completely pervaded today by the understanding of, how does
politics happen? Well, it depends on what the median voter wants and what the
median Senator wants, and all of that.

We have a lot of sophisticated analyses that try, with great
precision, to predict and describe existing systems in terms of an assumption of
universal rationality and a sub-assumption that what that rationality tries to
do is maximize returns to the self. Yet we live in a world where that's not
actually what we experience. The big question now is how we cover that distance
between what we know very intuitively in our social relations, and what we can
actually build with. ... [...continue
reading or watch the video...]

Even after central banks have pushed government bond prices as high as they
can go, they should keep buying government bonds for cash, in the hope that
people whose pockets are full of cash will spend more of it...

In addition, governments need to run extra-large deficits. Spending ...
boosts employment and reduces unemployment. And government spending is as good
as anybody else's.

Finally, governments should undertake additional measures to boost financial
asset prices, and so make it easier for those firms that ought to be expanding
and hiring to obtain finance on terms that allow them to expand and hire.

It is this point that brings us to US Treasury Secretary Timothy Geithner's
plan to take about $465 billion of government money, combine it with $35 billion
of private-sector money, and use it to buy up risky financial assets. The US
Treasury is asking the private sector to put $35 billion into this $500 billion
fund so that the fund managers all have some "skin in the game," and thus do not
take excessive risks with the taxpayers' money.

Private-sector investors ought to be more than willing to kick in that $35
billion, for they stand to make a fortune when financial asset prices close some
of the gap between their current and normal values. ... Time alone will tell
whether the financiers who invest in and run this program make a fortune. But if
they do, they will make the US government an even bigger fortune. ...

The fact that the Geithner Plan is likely to be profitable for the US
government is, however, a sideshow. The aim is to reduce unemployment. The
appearance of an extra $500 billion in demand for risky assets will reduce the
quantity of risky assets that other private investors will have to hold. ...
When assets are seen as less risky, their prices rise. And when there are fewer
assets to be held, their prices rise, too. With higher financial asset prices,
those firms that ought to be expanding and hiring will be able to get money on
more attractive terms.

The problem is that the Geithner Plan appears to me to be too small - between
one-eight and one-half of what it needs to be. Even though the US government is
doing other things as well -fiscal stimulus, quantitative easing, and other uses
of bailout funds - it is not doing everything it should.

My guess is that the reason that the US government is not doing all it should
can be stated in three words: Senator George Voinovich, who is the 60th vote in
the Senate - the vote needed to close off debate and enact a bill. To do
anything that requires legislative action, the Obama administration needs
Voinovich and the 59 other senators who are more inclined to support it. The
administration's tacticians appear to think that they are not on board -
especially after the recent AIG bonus scandal - whereas the Geithner Plan relies
on authority that the administration already has. Doing more would require a
legislative coalition that is not there yet.

We're losing, roughly, 600,000 jobs per month, which is about 20,000 per day. There are many costs associated with job loss, but I wonder how many foreclosures per day are generated from the loss of 20,000
jobs? And that's in addition to the foreclosures we'd have anyway.

The administration has an obligation to protect people from cyclical fluctuations in
the economy, to help them avoid losing their jobs, their houses, and other
sources of security. For example, if bank nationalization is the safer path to
pursue ex-ante to stabilize the banking system, then that means convincing the 60th vote in the Senate, one way
or the other, to support the action. If more fiscal stimulus, or a larger
version of the Geithner plan is needed, then there should be no rest until the
votes are there. If the "tacticians appear to think that they are not on board,"
or someone takes the time - as I hope they did - to ask them and finds out that,
in fact, they aren't aboard, then do whatever it takes to change that.

Maybe the effort was there prior to the Geithner plan, and maybe the effort
is there now to try to enhance the Geithner plan through legislative authority,
to set the stage for a second stimulus in case it's needed, and to change the
public perception of what has been done to date. Perhaps a lot of it is behind
the scenes, and all that can be done, is being done. Maybe the administration is saving political capital for other things. But prior to the
announcement of the Geithner plan, I had the impression that many of the minds
within the administration that counted the most were already made up, or if not
fully made up that they had a preference for clever market-based solutions (that
the public had no hope of understanding, which makes obtaining the public's
support much more difficult), and that stood in the way of a true full court
press toward nationalization. As for now, I also wonder if concerns within the
administration about the deficit are causing hesitation to pursue more
aggressive policies. So I'm not so sure that Voinovich was and is (or will be)
the only thing standing in the way.

Monday, March 30, 2009

Gavin Kennedy reacts to some of the recent criticism of economists for
reading and citing the sacred texts and ancient tomes:

Thought for the Day - 3, Adam Smith's Lost Legacy: ...There is a debate
underway among historians of economic thought on whether economists really need
to study the history of ideas in what we may loosely term our discipline. Those
economists who take the view that the history of economic ideas really has
nothing to do with modern economics, point to it being unnecessary for ‘real
scientists’ to read the works of Isaac Newton, and his lesser luminaries, so why
bother with Adam Smith and the rest?

My views on this debate (I have not joined in, so far) are predictable. The
physical world is fairly constant – each and every carbon atom is assumed to
behave the same way, and has done so through the ages, and unless that changes
in known circumstances, its properties and relationships with other atoms are
not expected to change. Knowledge gains in hard sciences build upon earlier
knowledge gains, and future knowledge gains continue the process.

Turning to economics – part of human sciences – it is quite different. We hardly
know about past economic history; even recent history is controversial and is well short of arriving at a settled view. There are political views of economic
behaviours – as far as I know, we do not have ‘leftwing’ or ‘rightwing’ carbon
atoms – and we do not have a settled view on what constitutes economic society
or on what would constitute a society that could be said to be the basis for all
further societies without (controversial) changes.

Simon Johnson's morality tale, by Dani Rodrik: Simon Johnson tells a simple
and compelling story:
the U.S. has been afflicted by a version of the crony capitalism that has been
the scourge of so many emerging markets, except that Wall Street has bought its
influence and power not by bribery but by shaping the ideology of our times...

The solution, to Simon, is equally clear. Finance needs to be cut down to
size. What the U.S. needs is what the IMF would have told any country...

As with any story built around clear villains easy solutions, there is
something in this account that is quite unsatisfying. For one thing, I think it
puts the blame too narrowly on the bankers. Yes, there can be little doubt that
banks badly misjudged the risks they were taking on. But they were aided in all
this by the broader economics and policymaking community--not because the latter
thought the policies in question were good for bankers, but because they thought
these would be good for the economy. Simon himself says as much. So why pick
on the bankers? Surely the blame must be spread much more widely.

And I find it astonishing that Simon would present the IMF as the voice of
wisdom on these matters--the same IMF which until recently advocated
capital-account liberalization for some of the poorest countries in the world
and which was totally tone deaf when it came to the cost of fiscal stringency in
countries going through similar upheavals (as during the Asian financial
crisis).

Simon's account is based on a very simple, and I believe misguided, theory of
politics and economics. It is an odd marriage of populist and technocratic
visions. Countries fail because political elites always end up in bed with
economic elites. The solution, apparently, is to let the technocrats (read the
IMF) run your affairs.

Among the many lessons from the crisis we should have learned is that
economists and policy advisors need greater humility. Too many of us thought we
had the right model when it turned out that we didn't. We pushed certain
policies with much greater confidence than we should have. Over-confidence bred
hubris (and the other way around).

Do we really want to exhibit the same self-confidence and assurance now, as
we struggle to devise solutions to the crisis caused by our own hubris?

[Dani is generally opposed to a global financial authority. He says "the logic of
global financial regulation is flawed." See his
article and the discussion at the
Rodrik Roundtable.]

The United States and Britain naturally want a system conducive to extending
their hegemony..., other countries would like to see more fundamental reform.
Russia and China are questioning the dollar as the pillar of the international
system. ... These are the calmer critics. ...Czech Prime Minister Miroslav
Topolanek, openly voiced the angry mood of many European leaders when he
described America's profligate approach to fiscal policy as "the road to hell."
He could just as well have said the same thing about European views on U.S.
financial leadership.

The stakes in the debate over international financial reform are huge. The
dollar's role at the center of the global financial system gives the U.S. the
ability to raise vast sums of capital without unduly perturbing its economy. ...

More fundamentally, the U.S. role at the center of the global financial
system gives tremendous power to U.S. courts, regulators, and politicians over
global investment throughout the world. That is why ongoing dysfunction in the
U.S. financial system has helped to fuel such a deep global recession. ...

Fear of crises is understandable, yet without these new, creative approaches
to financing, Silicon Valley might never have been born. Where does the balance
between risk and creativity lie?

Although much of the G-20 debate has concerned issues such as global fiscal
stimulus, the real high-stakes poker involves choosing a new philosophy for the
international financial system and its regulation.

If our leaders cannot find a new approach, there is every chance that
financial globalization will shift quickly into reverse, making it all the more
difficult to escape the current morass.

As I said
here in response to an op-ed by Becker and Murphy where they also express
concerns about regulatory overreach, my fear is the opposite, that powerful
interests will prevent us from taking the steps we need to take:

While it's possible that regulation will go overboard in response to the
crisis, there are powerful interests that will resist regulatory changes that
limit their opportunities to make money (and [anti-regulation] Nobel prize winning economists
willing to back them up), so my worry is that regulation will not go far enough,
particularly with people like Kashyap and Mishkin
arguing that we should wait for recovery before making any big regulatory
changes to the financial sector. They may be right that now is not the time to
change regulations because it could create additional destabilizing uncertainty
in financial markets, and that waiting will give us time to see how the crisis
plays out and give us the time to consider the regulatory moves carefully. But
as we wait, passions will fade, defenses will mount, the media will respond to
the those opposed to regulation by making it a he said, she said issue that fogs
things up and confuses the public as well as politicians, and by the time it is
all over there's every chance that legislation will pass that is nothing but a
facade with no real teeth that can change the behaviors that go us into this
mess.

I was talking about the U.S., but the same is true at an international level
where change is even harder to coordinate, and the danger that compromise to
please all will produce reform that does little to restrict behavior is even
greater.

I was asked to post this abridged version of a letter from Edmund Phelps to
G-20 leaders:

Financing Dynamism and Inclusion, by Edmund S. Phelps: This
commentary is based on an open letter sent to Prime Minister Gordon Brown and
other leaders of the G-20 ahead of their summit in London on April 2, 2009. The
unabridged version of the letter is published
here. The letter sums up the main recommendations presented in New York City
on February 20 at a conference at Columbia University’s Center on Capitalism and
Society. The conference,“Emerging from the Financial Crisis,” brought together
distinguished policymakers, bankers, regulators, journalists, and scholars. The
list of conference panelists, video excerpts, including Paul Volcker’s luncheon
speech, can be found
here.
Participants’ presentations, elaborating the conceptual foundations and policy
recommendations put forth at the conference, are
here.

When the G-20 leaders convene in London next week to propose measures to
address the global economic crisis, re-regulation of the financial sector will
be high on the agenda.

Although the need for re-regulation is clear, the key issue is how to design
regulation without discouraging funding for investment in innovation in the
non-financial business sector. In regulators’ understandable desire to rein in
the financial sector’s excesses, there is the danger that policymakers – often
pushed by the public – will adopt rules that dampen incentives and competition
to the point that the sources of dynamism in the economy are weakened.

The need to encourage entrepreneurship and ensure that young people have the
opportunity to start new businesses is acute. Even in the usually innovative
American economy, dynamism has declined over the current decade, with economic
inclusion – high employment rates and careers permitting ordinary people
throughout society to flourish – also decreasing.

The financial crisis has damaged our global authority, credibility, and
leadership, and that will make it much harder for the world to accomplish the essential task of coordinating a common response:

America
the Tarnished, by Paul Krugman, Commentary, NY Times: Ten years ago the
cover of Time magazine featured Robert Rubin,... Alan Greenspan,... and Lawrence
Summers... Time dubbed the three “the committee to save the world,” crediting
them with leading the global financial system through a crisis..., although it
was a small blip compared with what we’re going through now.

All the men on that cover were Americans, but nobody considered that odd.
After all, in 1999 the United States was the unquestioned leader of the global
crisis response. ... The United States, everyone thought, was the country that
knew how to do finance right.

How times have changed..., ... our claims of financial soundness — claims
often invoked as we lectured other countries on the need to change their ways —
have proved hollow.

Indeed, these days America is looking like the Bernie Madoff of economies:
for many years it was held in respect, even awe, but it turns out to have been a
fraud all along. ...

Simon Johnson..., who served as the chief economist at the IMF..., declares
that America’s current difficulties are “shockingly reminiscent” of crises in
places like Russia and Argentina — including the key role played by crony
capitalists.

In America as in the third world, he writes, “elite business interests —
financiers, in the case of the U.S. — played a central role in creating the
crisis, making ever-larger gambles, with the implicit backing of the government,
until the inevitable collapse. More alarming, they are now using their influence
to prevent precisely the sorts of reforms that are needed, and fast, to pull the
economy out of its nosedive.”

It’s no wonder, then, that an article in yesterday’s Times about the response
President Obama will receive in Europe was titled “English-Speaking Capitalism
on Trial.”

Now, in fairness ... the United States was far from being the only nation in
which banks ran wild. Many European leaders are still in denial about the
continent’s economic and financial troubles, which arguably run as deep as our
own... Still, it’s a fact that the crisis has cost America much of its
credibility, and with it much of its ability to lead.

And that’s a very bad thing... I’ve been revisiting the Great Depression,...
one thing that stands out ... is the extent to which the world’s response to
crisis was crippled by the inability of the world’s major economies to
cooperate.

The details of our current crisis are very different, but the need for
cooperation is no less. President Obama got it exactly right last week when he
declared: “All of us are going to have to take steps in order to lift the
economy. We don’t want a situation in which some countries are making
extraordinary efforts and other countries aren’t.”

Yet that is exactly the situation we’re in. I don’t believe that even
America’s economic efforts are adequate, but they’re far more than most other
wealthy countries have been willing to undertake. And by rights this week’s G-20
summit ought to be an occasion for Mr. Obama to chide and chivy European
leaders, in particular, into pulling their weight.

But these days foreign leaders are in no mood to be lectured by American
officials, even when — as in this case — the Americans are right.

The financial crisis has had many costs. And one of those costs is the damage
to America’s reputation, an asset we’ve lost just when we, and the world, need
it most.

In one credible scenario ... lie the seeds of recovery. Stock markets across
the globe have to be close to a turning point. Even if a stock market recovery
is quite modest, as I suspect it will be, the turnround may well have large (and
positive) economic consequences. ...

Global losses in publicly traded corporate equities [are]... almost
$35,000bn, a decline in stock market value of more than 50 per cent and an
effective doubling of the degree of corporate leverage. Added to that are
thousands of billions of dollars of losses of equity in homes and losses of
non-listed corporate and unincorporated businesses that could easily bring the
aggregate equity loss to well over $40,000bn, a staggering two-thirds of last
year’s global gross domestic product.

This combined loss has been critically important in the disabling of global
finance because equity capital serves as the fundamental support for all
corporate and mortgage debt and their derivatives. These assets are the
collateral that powers global intermediation, the process that directs a
nation’s saving into the types of productive investment that fosters growth. ...

A rise in global private sector equity will tend to raise the net worth (at
market prices) of virtually all business entities. ... In the current
environment, new equity will open up frozen markets and provide capital across
the globe to companies in general, and banks in particular. Greater equity,
after addressing the shortage of bank net worth, will support more bank lending
than currently available, enhance the market value of collateral (debt as well
as equity), and could reopen moribund debt markets. In short, liquidity should
re-emerge and solvency fears recede. ...

The substitution of sovereign credit for private credit has helped to fend
off some of the extremes of the solvency crisis. However, when we look back on
this period, I very much suspect that the force that will be seen to have been
most instrumental to global economic recovery will be a partial reversal of the
$35,000bn global loss in corporate equity values that has so devastated
financial intermediation. A recovery of the equity market, driven largely by a
receding of fear, may well be a seminal turning point of the crisis.

The key issue is when. Certainly by any historical measure, world stock
prices are cheap... The pace of economic deterioration cannot persist
indefinitely. ... The current pace of deterioration is bound to slow and with it
there should come a lessening of the level of fear. ...

As the level of fear recedes, stock market values will rise. Even if we
recover only half of the $35,000bn global equity losses, the quantity of newly
created equity value and the additional debt it can support are important
sources of funding for banks. As almost everyone is beginning to recognise,
restoring a viable degree of financial intermediation is the key to recovery.
Failure to do so will significantly reduce any positive impact from a fiscal
stimulus.

But then I grew up and made the unfortunate choice of pursuing a graduate degree
in economics. My mind was left rotted to the point where I could no longer
appreciate what most other people continued to believe was the self-evident
wisdom of Solomon.

The problem with Solomon's "solution" is that it adopts what in modern parlance
would be labeled a "behavioral approach." In other words, the solution relies
heavily on the assumption that people are "irrational" in a particular sense. It
turns out to be easy to be a wise philosopher king when one assumes that
everyone else is irrational. Perhaps this is why so many aspiring philosopher
kings today want to replace conventional economic theory with what they call
"behavioral economics."

Let's think about this. The "mechanism" (game) designed by Solomon proposes to
split the baby in two (sounds "fair" at least). One women screams out "No! Let
the other have the whole baby instead." The other woman coldly agrees to the
solution. The real mother is revealed in the obvious manner. What is not so
obvious is why the false mother could not have anticipated this outcome; a more
clever woman would have simply mimicked the behavior of the true mother.
Instead, the false mother fails to make this calculation (and instead adopts a
simple "behavioral" strategy; which is just a fancy label for irrational
behavior).

Now, perhaps there really are "irrational" people like the false mother. But
would you be willing to stake a baby's life on this assumption? Even if this
mechanism worked out one time, could we reasonably expect it to work in the
future (would people not learn from the outcome and tailor their strategies
accordingly?). If you believe that people are fundamentally irrational in this
sense, then you will make a fine behavioral economist (and a poor philosopher
king).

Daniel Little on Thomas Hobbes and the microfoundations of aggregate social outcomes. This is related to the discussion below on macroeconomic modeling, though it's more about how such models ought to be constructed than about the usefulness of models per se:

Hobbes an institutionalist?, by Daniel Little: Here is a surprising idea: of
all the modern political philosophers, Thomas Hobbes comes closest to sharing
the logic and worldview of modern social science. In
Leviathan (1651) he sets out the
problem of understanding the social world in terms that resemble a modern
institutionalist and rational-choice approach to social explanation. It is a
constructive approach, proceeding from reasoning about the constituents of
society, to aggregative conclusions about the wholes that are constituted by
these individuals. He puts forward a theory of agency -- how individuals reason
and what their most basic motives are. Individuals are rational and
self-concerned; they are strategic, in that they anticipate the likely behaviors
of other agents; and they are risk-averse, in that they take steps to avoid
attack by other agents. And he puts forward a description of two institutional
settings within which social action takes place: the state of nature, where no
"overawing" political institutions exist; and the sovereign state, where a
single sovereign power imposes a set of laws regulating individuals' actions.

Given the discussion below, it seems like a good time to rerun
this, a post that was suggested in a
comment from Hal Varian:

I've weighed in on this debate in
this essay. My
thesis is that economics should not be compared to physics but to engineering.
Or, alternatively, not to biology but to medicine. That is, economics is
inherently a "policy science" where the value of an economic theory should be
judged according to its contribution to economic policy.

There are many who disagree with this view, but hey, let a thousand flowers
bloom.

Here it is:

What Use is
Economic Theory?, by Hal R. Varian, August, 1989: Why is economic theory a
worthwhile thing to do? There can be many answers to this question. One obvious
answer is that it is a challenging intellectual enterprise and interesting on
its own merits. A well-constructed economic model has an aesthetic appeal
well-captured by the following lines from Wordsworth:

Mighty is the charm
Of these abstractions to a mind beset
With images, and haunted by herself
And specially delightful unto me
Was that clear synthesis built up aloft
So gracefully.

No one complains about poetry, music, number theory, or astronomy as being
‘‘useless,’’ but one often hears complaints about economic theory as being
overly esoteric. I think that one could argue a reasonable case for economic
theory on purely aesthetic grounds. Indeed, when pressed, most economic
theorists admit that they do economics because it is fun.

But I think purely aesthetic considerations would not provide a complete
account of economic theory. For theory has a role in economics. It is not just
an intellectual pursuit for its own sake, but it plays an essential part in
economic research. The essential theme of this essay that economics is a policy
science and, as such, the contribution of economic theory to economics should be
measured on how well economic theory contributes to the understanding and
conduct of economic policy.

In October 1989, I attended a conference at the National Bureau of Economic
Research ... on “The Risk of Economic Crisis.” The conference still sticks in my
mind because of a paper delivered there by Lawrence H. Summers... I came away
with a recognition that a severe contraction, even a depression, could indeed
come again. (His and other papers from the conference are
here.)

Mr. Summers told a fictional but vivid story of a big financial crisis ... He
said that this crisis would be preceded by an enormous stock market boom,
bringing the Dow to the unimagined high... Euphoria gripped the investors of his
fictional universe. “The notion that recessions were a thing of the past took
hold,” Mr. Summers said. ... The popular view was that “with a reduced cyclical
element, the future would be even brighter.”

Furthermore, he said, “lawyers and dentists explained to one another that
investing without margin was a mistake, since using margin enabled one to double
one’s return, and the risks were small given that one could always sell out if
it looked like the market would decline.” ...

His fictional account went on to describe the early signs of the crisis,
“...problems began to surface,” he said, adding that a “major Wall Street firm
was forced to merge with another after a poorly supervised trader lost $500
million by failing to properly hedge a complex position in the newly developed
foreign-mortgage-backed-securities market.” He went on to describe how this
provocation led to a change in psychology and a market crash and problems in
banks and credit markets.

His fiction concluded, “The result was the worst recession since the
Depression.”

How did he write a story 20 years ago that sounds so much like what we are
experiencing now? It seems that he was looking at factors of human psychology...
Mr. Summers evidently knew that an event like our current crisis was waiting to
happen, someday.

Ultimately, the record bubbles in the stock market after 1994 and the housing
market after 2000 were ... driven by a view of the world born of complacency
about crises, driven by views about the real source of economic wealth, the
efficiency of markets and the importance of speculation in our lives. It was
these mental processes that pushed the economy beyond its limits, and that had
to be understood to see the reasons for the crisis.

Of course, forecasts based on a theory of mind are subject to egregious
error. They cannot accurately predict the future. But the uncomfortable truth
has to be that such forecasts need to be respected alongside econometric
forecasts, which cannot reliably predict the future, either.

Still, in our current crisis, we need to try to understand the perils we
face. The motivation for a vigorous economic recovery program must come, at
least in part, from our forecasts of the dangers ahead. The greatest risk is
that appropriate stimulus will be derailed by doubters who still do not
appreciate the true condition of our economy.

Exactly how to implement this forecasting technique - one based upon a theory of the mind - is a bit vague.

Your posting of Kaletsky’s article has led to a much overdue discussion of
the usefulness of mathematical formalism for understanding market outcomes. This
is particularly important as the recent discussions of failures of economic
models have focused on specific assumptions, such as incompleteness of markets,
contracts or nonlinearities (Willem Buiter), or neo-Keynesian versus new
classical approaches (Paul Krugman).

The attached note, which draws heavily on my recent book and subsequent
papers with Michael Goldberg, argues that the question of whether and what type
of mathematical formalism can help us understand market outcomes in modern
capitalism is more subtle than Kaletsky’s critics might have realized.

Here's the note:

What type of mathematical formalism can help us understand market outcomes
in modern capitalism?

Mark Thoma reports that the article by Anatole Kaletsky
Goodbye, homo economicus, calling for an intellectual revolution in
economics, “did not get the best reception here and elsewhere, and there were
also protests that arrived by email.”

What really irked Kaletsky’s antagonists was his attack on the use of
mathematical formalism in economics. But what has gone completely unnoticed in
the subsequent discussion is that Kaletsky’s attack on mathematical formalism
focused not on the use of mathematics in economics as such, but on the portrayal
by contemporary models of the “market economy as a mechanical system.”

This characterization of contemporary macro and finance models seems
uncontroversial. Regardless of whether these models are based on REH or
behavioral considerations, they represent the causal mechanisms that supposedly
underpin change on individual and aggregate levels through mechanical rules.
Thus, they ignore the key feature of modern economies: the fact that individuals
and companies engage in innovative activities, discovering new ways of using
existing physical and human capital and technology, as well as new technologies
and new capital in which to invest.

Moreover, the institutions and the broader social context within which this
entrepreneurial activity takes place also change in novel ways. Innovation in
turn influences future returns from economic activity in ways that no one,
including economists, and market participants, can fully foresee, and thus that
do not conform to any rule that can be prespecified in advance.

In our recent book, Imperfect Knowledge Economics (IKE), Michael Goldberg and I trace the empirical failures and fundamental
epistemological flaws within the contemporary models of “rational” or
“irrational” behavior to a common source: in modeling aggregate outcomes,
contemporary economists fully prespecify the causal mechanism that underpins
change in real-world markets.

To remedy this flaw, IKE jettisons mechanical models of change and attempts
to construct economic models of individual behavior and aggregate outcomes on
the basis of qualitative regularities that can be formalized with
mathematical conditions. An aggregate model based on such micro-foundations
generates only qualitative predictions of market outcomes.

This brings us back to the key question: whether, and if so, some
mathematical formalism might be useful in our quest to understand individual
behavior and market outcomes.

Friday, March 27, 2009

The failure of ratings agencies to properly price the risky securities at the
heart of the financial crisis has been attributed to conflict of interest (being
paid by the issuers of the assets they are rating) and shopping for the best
rating (get more than one rating, then only make public the highest one).
However, an objection to these explanations is that these incentives have always
existed, yet the problems did not emerge until recently. Thus, any explanation
relying upon these incentives must explain why they did not cause problems until
recently.

This article says the answer can be found in the complexity of the assets
that are being rated. When the assets are very simple, risk assessment is not
very complicated and the dispersion of ratings across agencies is very low.
Thus, there is no incentive to shop around. In addition, it is hard for the
agencies to become beholden to asset issuers and inflate ratings because such
behavior would be transparent enough so as to risk losing credibility. That is,
people outside the agencies can independently check and verify the ratings
easily so any manipulation of the ratings would be easy to discover, and the
revelation that their ratings are inflated would damage their credibility and
hence their business.

But all of this changes when the assets become more complex. First, because
of the complexity the dispersion of ratings across agencies will increase. Thus,
even if the mean rating does not change, the variance of the ratings make it
worthwhile to pay for more than one rating and cherry pick the best of the lot,
i.e. to shop around. (In numerical terms, suppose assets are rated from 1, which
is the highest risk category, to 10 which is the safest. A non-complex asset
might have a dispersion of, say, 7.95 to 8.05 among a fixed number of ratings
agencies, while a complex asset might have ratings running from 6.50 to 9.50. In
both cases, assuming a symmetric distribution, the mean is 8, but the rewards to
shopping around are quite different).

Second, it is easier for the issuer to capture the rating agency, i.e. for
the agency to produce the ratings the company is looking for, because the
complexity makes such behavior harder to uncover. The ability of outside
observers to uncover such behavior diminishes when the variance of the ratings
goes up.

To be more precise about the incentive to shop around, there is a cost to obtaining one
more rating, the fee the firm must pay (though the article below implies the
firm can escape the fee it if doesn't like the rating it
gets). The benefit is the chance that the new, incremental rating will be higher
than the ratings already in hand, and this diminishes as more ratings are
collected, i.e. there is a declining marginal benefit. If the fee is relatively
low, it will be worthwhile to collect many ratings, and the expected rating
outcome - the maximum of the ratings - will be higher as more ratings are
collected. However, issuers do not necessarily collect ratings from every
ratings firm since the expected benefit of an additional rating may not cover
the cost. But if the fees are sufficiently low, if the assets are sufficiently
complex, and if the number of firms is sufficiently small - a case that may
describe the recent market fairly well - a corner solution will emerge, i.e. it
always pays - in expected terms - to collect all the ratings available and then
make only the best rating public.

The other side of this, though, is that the degree of distortion falls when
the number of ratings agencies is small. That is, the expected maximum rating is
increasing in the number of ratings collected (though the increase comes at a
decreasing rate, that's why there is a declining marginal benefit to collecting
another rating). It depends upon the nature of the underlying distributions, but
it's possible - and I think likely - that the distortion from this factor was
low due to the fact that there were only, effectively, Moody and Standard &
Poor operating in these markets (do we count Fitch too?). If so, if the shopping around distortion is relatively minor
because the number of firms is small (and that is highly speculative on my
part, and based upon the quick reactions scribbled out above rather than days of careful thought), then the alternative explanation that the ratings agencies were beholden to asset
issuers should be given more weight as the likely, predominant explanation for
the problems in these markets.

In any case, here's the article:

The origin of bias in
credit ratings, by Vasiliki Skreta and Laura Veldkamp, voxeu.org: Most market observers attribute the recent credit crunch to a confluence of factors – excess leverage, opacity, improperly estimated correlation between bundled assets, lax screening by mortgage originators, and market-distorting regulations. Credit
rating agencies were supposed to create transparency, provide the basis for
risk-management regulation, and discipline mortgage lenders and the creators of
structured financial products by rating their assets. Understanding the origins
of the crisis requires, at least in part, understanding the failures of the
market for ratings. Proposed explanations for ratings bias have broadly fallen
into three categories.

The Market
Mystique, by Paul Krugman, Commentary, NY Times: On Monday, Lawrence Summers
... responded to criticisms of the Obama administration’s plan to subsidize
private purchases of toxic assets. “I don’t know of any economist,” he declared,
“who doesn’t believe that better functioning capital markets in which assets can
be traded are a good idea.” ...

Quite a few economists have reconsidered their favorable opinion of capital
markets and asset trading in the light of the current crisis. But it has become
increasingly clear ... that top officials in the Obama administration are still
in the grip of the market mystique. They still believe in the magic of the
financial marketplace and in the prowess of the wizards who perform that magic.

The market mystique didn’t always rule financial policy. America emerged from
the Great Depression with a tightly regulated banking system, which made finance
a staid, even boring business. ... And the financial system wasn’t just boring.
It was also, by today’s standards, small. ... It all sounds primitive... Yet
that boring, primitive financial system serviced an economy that doubled living
standards over the course of a generation.

After 1980, of course, a very different financial system emerged. In the
deregulation-minded Reagan era, old-fashioned banking was increasingly replaced
by wheeling and dealing on a grand scale. The new system was much bigger than
the old regime: On the eve of the current crisis, finance and insurance
accounted for 8 percent of G.D.P., more than twice their share in the 1960s. ...
And finance became anything but boring. It attracted many of our sharpest minds
and made a select few immensely rich.

Underlying the glamorous new world of finance was the process of
securitization. Loans no longer stayed with the lender. Instead, they were sold
on to others, who sliced, diced and pureed individual debts to synthesize new
assets. Subprime mortgages, credit card debts, car loans — all went into the
financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA
investments. And financial wizards were lavishly rewarded for overseeing the
process.

But the wizards were frauds, whether they knew it or not, and their magic
turned out to be no more than a collection of cheap stage tricks. Above all, the
key promise of securitization — that it would make the financial system more
robust by spreading risk more widely — turned out to be a lie. Banks used
securitization to increase their risk, not reduce it, and in the process they
made the economy more, not less, vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did. ...
Which brings us back to the Obama administration’s approach to the financial
crisis.

Much discussion of the toxic-asset plan has focused on the details and the
arithmetic, and rightly so. Beyond that, however, what’s striking is the ...
administration seems to believe that once investors calm down, securitization —
and the business of finance — can resume where it left off a year or two ago.

To be fair, officials are calling for more regulation. ... But the underlying
vision remains that of a financial system more or less the same..., albeit
somewhat tamed by new rules.

As you can guess, I don’t share that vision. I don’t think this is just a
financial panic; I believe that it represents the failure of a whole model of
banking, of an overgrown financial sector that did more harm than good. I don’t
think the Obama administration can bring securitization back to life, and I
don’t believe it should try.

Without a firm guarantee up front that the Federal government will
fully re-capitalize the Fed for losses suffered as a result of the
Fed’s exposure to private credit risk, the Fed will have to go
cap-in-hand to the US Treasury to beg for resources. Even if it gets
the resources, there is likely to be a price tag attached – that is, a
commitment to pursue the monetary policy desired by the US Treasury,
not the monetary policy deemed most appropriate by the Fed.

Butier's tone suggests that the Fed is not aware of these risks. But
I think the opposite is very much the case - the Fed is agonizing over
this issue. See the Fed-Treasury accord
that
was issued earlier this week; it is a clear effort on the part of the
Fed to firmly establish its independence. Note also that some
policymakers have made clear their concerns about mixing monetary and
fiscal policy. Richmond Fed President Jeffrey Lacker hit on the point this week:

Thursday, March 26, 2009

Sach at The Compulsive Theorist looks at the case for behavioral reform in
financial markets, and argues that fixing balance sheets without fixing norms
and culture is unlikely to provide a permanent solution to the problems these
markets face:

Why the culture of the financial sector has to change, the Compulsive Theorist:
I want to say a little about business and cultural norms in the financial
sector, how they affect tangible outcomes we all care about, and why they need
to change. Norms are inherently less tangible than items on balance sheets, so
it can be hard to see the role they play. I want to focus on norms in the
financial sector, but to bring them out of the background I’ll start with a
comparison to another field.

Doctors and bankers are alike in that they can inflict enormous damage by doing
a bad job, doctors with a flick of the scalpel, bankers with a click of the
mouse. Both are therefore subject to regulation which tries to trade-off costs
of enforcement against risk of damage. But there’s a huge difference in the way
doctors and bankers view their work. ... [...continue reading...]

The article by Anatole Kaletsky I posted earlier today,
Goodbye, homo economicus, did not get the best reception here and elsewhere, and
there were also protests that arrived by email. Here's a follow-up on one aspect of the article, the use of formal mathematical models in economics. This article is by David Colander:

Marshallian General Equilibrium Analysis, by David Colander: In an
assessment of Alfred Marshall, Paul Samuelson (1967) writes that “The
ambiguities of Alfred Marshall paralyzed the best brains in the Anglo-Saxon
branch of our profession for three decades.“ In making this assessment he
carried on a tradition of Marshall-bashing that has a long history in economics,
dating back to Stanley Jevons and F. Y. Edgeworth, who accused Marshallian
economists of being seduced by “zig zag windings of the flowery path of
literature.” (Edgeworth, 1925)

These harsh assessments of Marshall and his approach to
economics have had their influence on the modern profession and, other than
historians of economic thought, few young economists know much about him. Fewer
still would see themselves as Marshallians.[1]

Today, Marshall is best remembered for his contribution to
partial equilibrium supply and demand analysis.[2] For the true economic
theorists of the 1990s, however, this contribution is de minimus; the partial
equilibrium approach is for novice economists with no stomach for real economic
theory—general equilibrium. The profession’s collective view of Marshall in the
1990s is that Marshall is passé--at most a pedagogical stepping stone for
undergraduate students, but otherwise quite irrelevant to modern economics.

Are we about to reach bottom? If and when we do, will we bounce back upward and
recover, or will we bounce along the bottom in a series of fits and starts as the economy stagnates at a sub-par equilibrium?

Tim Duy:

Looking For a Bottom, by Tim Duy: Given the length and depth of the current recession, it is natural for
analysts to start looking for a bottom. In such an environment, bad news will
be ignored while the seemingly good news is overblown. For example, the most
recent initial unemployment claims report indicates that labor markets continue
to deteriorate; we have yet to see a turning point consistent with improved
conditions. Likewise, the durable goods report was heralded as a positive sign,
but the jump in this volatile series needs to be taken in context of the severe
drop the previous month. The chart of nonair/nondefense new orders is not
particularly encouraging:

That said, things will eventually get less worse, if only because some
sectors, such
as new residential housing, will hit a bottom. And that bottom is not
likely to be zero, and, I suspect, that bottom will be late this year or, at
worst, early next year. That should not, however, be confused with an
optimistic outlook, as the durability and strength of the eventual recovery is
in doubt. I am confident that the economy will not spiral downward endlessly; I
am more worried that the we will be left at a suboptimal equilibrium chiefly
characterized by low growth and persistently high unemployment.

"In the past few years, we’ve seen too much greed and too little fear;
too much spending and not enough saving; too much borrowing and not enough
worrying," Summers said Friday in a speech to the Brookings Institution. "Today,
however, our problem is exactly the opposite."

Borrowing, you see, is evidently linked to greed; especially if one borrows
too much. I am reminded of university students who mindlessly accumulate too
much student debt. The greedy bastards. Or of poor people mindlessly borrowing
to finance a home purchase. The greedy SOBs. There is too much borrowing; too
much spending; there is too much greed.

Saving, on the other hand, is evidently linked to fear. Fear is a virtue (as in
the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000.
Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets,
like government treasuries (backed by virtuous/coercive taxation; rather than
the prospect of future cash flow from a successful enterprise). Yes, fear is a
virtue...unless there is too much fear. Then fear is bad.

Let me follow-up on the post below this one with a couple of quick thoughts.

First, academic economists have taken a lot of grief for not predicting the crisis, but realize that very few academic economists do forecasting. There are two uses of economic and econometric models, one is to use the models to understand how the world works, the other is to use the models to forecast. And while, of course, one of the goals of understanding the economy is to be able to predict it, it is simply not something most academic economists do (and the best models for forecasting are not necessarily the same as the best models for learning about how the economy works). Business economists do lots of prediction and forecasting, but academic economists? Not so much. We come along long after events have occurred - e.g. we're still analyzing the Great Depression to some extent - and try to use those events (as well as data from normal times) to try to understand how the economic world works, how policy can improve performance, etc.

Second, the economists who do forecasting need better data. If we are we are going to forecast the immediate future accurately, we need data that are timely and informative. There can be big differences between forecasts made using the initial data releases, and those made once the data is revised, often months later. We simply do not have an accurate picture of aggregate activity over, say, the last month or two, even longer in some cases, due to data collection lags and other problems, and without accurate contemporaneous data, it's not possible to produce accurate forecasts (e.g. GDP data are three months old when you get them, and they are revised three months later, then again even later than that though those adjustments tend to be smaller. So we don't get a good picture of GDP until six months after it happens). It's like being asked what the weather will be like tomorrow, but only having weather data that is a month or more old.

I've been wondering if I should call for enhanced investment in data collection as part of the response to this crisis. However, much of the problem is that the data come from reports that are filed quarterly, annually, etc., and the data collection agencies must wait for those reports before they can produce initial estimates or revisions. Those delays are fairly lengthy relative to our data needs, and it's not clear to me that more money can overcome these lags in the process. Assembling these reports accurately, then interpreting them properly and then turning them into macroeconomic aggregates takes time.

But there must be some way we can get a better picture of what is going on contemporaneously than we have now, and I think we need to investigate how to make that happen. The data as they exist now are fine for academic researchers who are looking backward and do not necessarily need the very latest months worth of data, though even in this setting this is sometimes a problem, but for forecasting our data are inadequate. Maybe with some investment in the process there would be a way to go out and collect contemporaneous data from all the electronic sources of sales and other information that didn't exist in the past, or to sample more traditional data sources in a more timely fashion. Obviously, I don't have the exact answer to this problem, but I do think it's something we should put some thought into, and if there's a way to do substantially better at getting an accurate picture of the current economy than we have now, something that would be of great benefit to policymakers, forecasters, and people trying to make economic decisions in the private sector, it would be well worth pursuing.

Via an email suggestion (there's much, much more in the
full version):

Goodbye, homo economicus, by Anatole Kaletsky: Was Adam Smith an
economist? Was Keynes, Ricardo or Schumpeter? By the standards of today’s
academic economists, the answer is no. Smith, Ricardo and Keynes produced no
mathematical models. Their work lacked the “analytical rigour” and precise
deductive logic demanded by modern economics. And none of them ever produced an
econometric forecast (although Keynes and Schumpeter were able mathematicians).
If any of these giants of economics applied for a university job today, they
would be rejected. As for their written work, it would not have a chance of
acceptance in the Economic Journal or American Economic Review. The editors, if
they felt charitable, might advise Smith and Keynes to try a journal of history
or sociology.

If you think I exaggerate, ask yourself what role academic economists have
played in the present crisis. Granted, a few mainstream economists with
practical backgrounds—like Paul Krugman and Larry Summers in the US—have been
helpful explaining the crisis to the public and shaping some of the response.
But in general how many academic economists have had something useful to say
about the greatest upheaval in 70 years? The truth is even worse than this
rhetorical question suggests: not only have economists, as a profession, failed
to guide the world out of the crisis, they were also primarily responsible for
leading us into it. ...

Academic economists have thus far escaped much blame for the crisis. Public
anger has focused on more obvious culprits: greedy bankers, venal politicians,
sleepy regulators or reckless mortgage borrowers. But why did these scapegoats
behave in the ways they did? Even the greediest bankers hate losing money so why
did they take risks which with hindsight were obviously suicidal? The answer was
beautifully expressed by Keynes 70 years ago: “Practical men, who believe
themselves to be quite exempt from any intellectual influence, are usually the
slaves of some defunct economist. Madmen in authority, who hear voices in the
air, are distilling their frenzy from some academic scribbler of a few years
back.”

What the “madmen in authority” heard this time was the distant echo of a
debate among academic economists begun in the 1970s about “rational” investors
and “efficient” markets. This debate began against the backdrop of the oil shock
and stagflation and was, in its time, a step forward in our understanding of the
control of inflation. But, ultimately, it was a debate won by the side that
happened to be wrong. And on those two reassuring adjectives, rational and
efficient, the victorious academic economists erected an enormous scaffolding of
theoretical models, regulatory prescriptions and computer simulations which
allowed the practical bankers and politicians to build the towers of bad debt
and bad policy. ...

Which brings us to the causes of the present crisis. The reckless property
lending that triggered this crisis only occurred because rational investors
assumed that the probability of a fall in house prices was near zero. Efficient
markets then turned these assumptions into price-signals, which told the bankers
that lending 100 per cent mortgages or operating with 50-to-1 leverage was safe.
Similarly, regulators, who allowed banks to determine their own capital
requirements and private rating agencies to establish the value at risk in
mortgages and bonds, took it as axiomatic that markets would automatically
generate the best possible information and create the right incentives for
managing risks. ...

The scandal of modern economics is that these two false theories—rational
expectations and the efficient market hypothesis—which are not only misleading
but highly ideological, have become so dominant in academia (especially business
schools), government and markets themselves. While neither theory was totally
dominant in mainstream economics departments, both were found in every major
textbook, and both were important parts of the “neo-Keynesian” orthodoxy, which
was the end-result of the shake-out that followed Milton Friedman’s attempt to
overthrow Keynes. The result is that these two theories have more power than
even their adherents realise: yes, they underpin the thinking of the wilder
fringes of the Chicago school, but also, more subtly, they underpin the analysis
of sensible economists like Paul Samuelson.

The rational expectations hypothesis (REH), developed by two Chicago
economists, Robert Lucas and Thomas Sargent in the 1970s, asserted that a market
economy should be viewed as a mechanical system that is governed, like a
physical system, by clearly-defined economic laws which are immutable and
universally understood. Despite its obvious implausibility and the persistent
attacks on it, especially from the left, REH has continued to be regarded by
universities and funding bodies as the most acceptable foundation for serious
academic research. In their recent book Imperfect Knowledge Economics, two
American professors, Roman Frydman and Michael Goldberg, complain that “all
graduate students of economics—and increasingly undergraduates too—are taught
that to capture rational behaviour in a scientific way they must use REH.” In
Britain too the REH orthodoxy has remained far more powerful than is often
realised. As David Hendry, until recently head of the Oxford economics
department, has noted: “Economists critical of the rational expectations based
approach have had great difficulty even publishing such views, or maintaining
research funding. For example, recent attempts to get ESRC funding for a project
to test the flaws in rational expectations based models was rejected. I believe
some of British policy failures have been due to the Bank accepting the
implications [of REH models] and hence taking about a year too long to react to
the credit crisis.” ...

To make matters worse, rational expectations gradually merged with the
related theory of “efficient” financial markets. ... This was the efficient
market hypothesis (EMH), developed by another group of Chicago-influenced
academics, all of whom received Nobel prizes just as their theories came apart
at the seams. EMH, like rational expectations, assumed that there was a
well-defined model of economic behaviour and that rational investors would all
follow it; but it added another step. In the strong version of the theory,
financial markets, because they were populated by a multitude of rational and
competitive players, would always set prices that reflected all available
information in the most accurate possible way. Because the market price would
always reflect more perfect knowledge than was available to any one individual,
no investor could “beat the market”—still less could a regulator ever hope to
improve on market signals by substituting his own judgment. ...

Why did such discredited theories flourish? Largely because they justified
whatever outcomes the markets happened to decree—laissez-faire ideology, big
salaries for top executives and billions in bonuses for traders. And,
conveniently, these theories were regarded as the gold-standard by academic
economists who won Nobel prizes.

So what is to be done? There are two options. Either economics has to be
abandoned as an academic discipline, becoming a mere appendage to the collection
of industrial and social statistics. Or it must undergo an intellectual
revolution. ...

Economics today is a discipline that must either die or undergo a paradigm
shift—to make itself both more broadminded, and more modest. It must broaden its
horizons to recognise the insights of other social sciences and historical
studies and it must return to its roots. Smith, Keynes, Hayek, Schumpeter and
all the other truly great economists were interested in economic reality. They
studied real human behaviour in markets that actually existed. Their insights
came from historical knowledge, psychological intuition and political
understanding. Their analytical tools were words, not mathematics. They
persuaded with eloquence, not just formal logic. One can see why many of today’s
academics may fear such a return of economics to its roots.

Academic establishments fight hard to resist such paradigm shifts, as Thomas
Kuhn, the historian of science who coined the phrase in the 1960s, demonstrated.
Such a shift will not be easy, despite the obvious failure of academic
economics. But economists now face a clear choice: embrace new ideas or give
back your public funding and your Nobel prizes, along with the bankers’ bonuses
you justified and inspired.

And it fleeces the taxpayer a second way: the public has spent enough money on
both banks so that in an economic sense, they ought to have been nationalized.
Yet for reasons that are largely ideological and cosmetic (the banks' debt would
need to be consolidated were they owned 100% by Uncle Sam), they remain private.
So not only are they seeking to extract far more than was intended even with the
already generous subsidies embodied in this program, but this activity is also
speculating with taxpayer money.

This sort of thing was predicted here and elsewhere. Welcome to yet more
looting.

As Treasury Secretary Tim Geithner orchestrated a plan to help the nation's
largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of
America have been aggressively scooping up those same securities in the
secondary market, sources told The Post...

But the banks' purchase of so-called AAA-rated mortgage-backed securities,
including some that use alt-A and option ARM as collateral, is raising eyebrows
among even the most seasoned traders. Alt-A and option ARM loans have widely
been seen as the next mortgage type to see increases in defaults.

One Wall Street trader told The Post that what's been most puzzling about the
purchases is how aggressive both banks have been in their buying, sometimes
paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the
dollar, and most of the buyers have been hedge funds acting opportunistically on
a bet that prices will rise over time. However, sources said Citi and BofA have
trumped those bids.

The secondary market represents a key cog in the mortgage market, and serves as
a platform where mortgage originators can offload mortgages in bulk that have
been converted into bonds.

Yields on such securities can be as high as 22 percent, one trader noted.

BofA said its purchases of secondary-mortgage paper are part of its plans to
breathe life back into the moribund securitization market....

While some observers concur that the buying helps revive a frozen market, others
argue the banks are gambling away taxpayer funds instead of lending.

Moreover, the MBS market has been so volatile during the economic crisis that a
number of investors who already bet a bottom had been reached have gotten
whacked as things continued to slide.

Around this same time last year some of the same distressed mortgage paper that
Citi and BofA are currently snapping up was trading around 50 cents on the
dollar, only to plummet to their current levels.

One source said that the banks' purchases have helped to keep prices of these
troubled securities higher than they would be otherwise.

Both banks have launched numerous measures to help stem mortgage foreclosures,
and months ago outlined to the government their intention to invest in the
secondary market to expand the flow of credit.

The Other Chicago School, by Elisabeth Eaves, Forbes: You may think the
economic meltdown is hitting bankers and Realtors hard, but spare a thought for
members of the underground economy--prostitutes, drug dealers and purveyors of
stolen goods, to name just a few participants. That's what sociologist Sudhir
Venkatesh does, having spent much of the last 15 years studying, and sometimes
living within, the underground economies of New York and Chicago.

"The recession is engendering more violence," says Venkatesh, a professor at
Columbia University. "There's far greater competition for whatever meager
resources there are. The folks down on Wall Street peddling drugs, they're
fighting. The sex workers are trying as hard as they can to retain their
clients," he says...

Venkatesh is watching black market workers slip into despair along with
the rest of the population affected by the economy. Lest legal workers consider
this a distant problem, one conclusion of Venkatesh's work is that the
underground and mainstream economies are intimately entwined. "The boundaries
are fluid, particularly in the global city where the black market has become
instrumental--one might even say vital--to the overall economy," he says. In New
York City illegal workers serve sex, drugs and takeout to the wealthiest members
of society--or at least they did until financial sector layoffs began in 2008.

The underground economy includes a vast array of people providing services
that are off the books but otherwise legal. ... And as business contracts,
underground workers face certain problems unique to their status. They have no
unemployment insurance or other benefits, and, with little protection from law
enforcement, they tend to resolve disputes by physical means. ...

Venkatesh is struck by how much the black market resembles the wider society
in which it is enmeshed. In the same Parisian banlieues that erupted in riots in
2005, he observed an "almost aristocratic," highly centralized criminal
operation. In the ghettos of Chicago, by contrast, he observed underground
workers convene an ad hoc court to solve a dispute. His dismisses the "culture
of poverty" theory, which suggests that poor blacks in America don't work
because they don't value employment. "People in America want to work," he says.
They do so ever so industriously, even when they're breaking the law.

Lender of last resort:
Put it on the agenda!, by Guillermo Calvo, Vox EU: The subprime crisis is a
massive failure of the shadow banking system that has affected all corners of
the capital market and triggered worldwide deleveraging. We are in a severe
credit crunch. Savers distrust private-sector dissavers, which gives rise to a
fall in aggregate demand and a search for safe assets (“flight to quality”).

Therefore, the first priority should be to increase credit to the private
sector. The trouble is that the process of deleveraging – partly explained by
the virtual disappearance of investment banks – induces banks to lower their
risk exposure. This is evident in the failure to produce noticeable credit
expansion, despite bank recapitalisation and the US Federal Reserve’s absorption
of commercial paper. Moreover, the credit crunch depresses asset prices and
further discourages credit expansion, launching the economy into a vicious
cycle.

Fiscal stimulus packages are second-best. These packages can help restore
liquidity in the private sector and consequently increase capacity utilisation
and employment. But rapid effects are unlikely, because output is
credit-constrained and liquidity accumulation is time-consuming. Thus, solutions
should aim directly at restoring credit availability.

In a report scheduled to be released Wednesday, the Government Accountability
Office found that ... the Labor Department’s Wage and Hour Division, had
mishandled 9 of the 10 cases brought by a team of undercover agents posing as
aggrieved workers.

In one case, the division failed to investigate a complaint that under-age
children in Modesto, Calif., were working during school hours at a meatpacking
plant with dangerous machinery...

When an undercover agent posing as a dishwasher called four times to complain
about not being paid overtime for 19 weeks, the division’s office in Miami
failed to return his calls for four months, and when it did, the report said, an
official told him it would take 8 to 10 months to begin investigating his case.

“This investigation clearly shows that Labor has left thousands of actual
victims of wage theft who sought federal government assistance with nowhere to
turn,” the report said. “Unfortunately, far too often the result is unscrupulous
employers’ taking advantage of our country’s low-wage workers.”

The report pointed to a cavalier attitude by many Wage and Hour Division
investigators... During the nine-month investigation, the report said, 5 of the
10 labor complaints that undercover agents filed were not recorded in the Wage
and Hour Division’s database, and three were not investigated. In two cases,
officials recorded that employers had paid back wages, even though they had not.

The accountability office also investigated hundreds of cases that it said
the Wage and Hour Division had mishandled. ...

Secretary of Labor Hilda L. Solis said she took the report’s findings
seriously. ... Ms. Solis said the Wage and Hour Division planned to increase its
staff by a third by hiring 250 investigators — 100 of them as part of the
federal stimulus package — “to refocus the agency on these enforcement
responsibilities”...

Ms. Solis’s predecessor, Elaine L. Chao, often defended the Wage and Hour
Division, saying it had concentrated on larger, tougher cases, and secured back
wages for more than 300,000 workers a year and collected more than twice as much
annually as the division had done in the final years of the Clinton
administration.

The report concluded that the Wage and Hour Division had mishandled more
serious cases 19 percent of the time. ...

I don't have the data to answer it, but the obvious question is whether this
was any different before the Bush administration. However, the discussion about
shifting enforcement to larger employers under Chao makes it appear that it was
different, and Chao's defense makes it seem like taking on big versus small
employers is an either-or choice, but it's not. If Republicans had wanted to
increase the budget to allow effective enforcement of labor law on behalf of workers at both large and small employers, they could have. It's not like the Democrats would have opposed more
effective minimum wage enforcement, or other such proposals. It was a matter of
priorities, and this wasn't deemed important enough to draw additional budgetary
resources from other purposes (if they thought about it much at all). Hopefully
that will change, and the additional investigators that will be hired as well as the change in leadership and direction within the agency is a start to that process.

Tuesday, March 24, 2009

Chris Carroll
supports the Geithner plan, but I don't think we can say the same about Jeff
Sachs:

Will Geithner and
Summers Succeed in Raiding the FDIC and Fed?, by Jeffrey Sachs, Vox EU:
Geithner and Summers have now announced their plan to raid the Federal Deposit
Insurance Corporation (FDIC) and Federal Reserve (Fed) to subsidize investors to
buy toxic assets from the banks at inflated prices. If carried out, the result
will be a massive transfer of wealth -- of perhaps hundreds of billions of
dollars -- to bank shareholders from the taxpayers (who will absorb losses at
the FDIC and Fed). Soaring bank share prices on the morning of the announcement,
and in the week of leaks and hints that preceded it, are an indication of the
mass bailout at work. There are much fairer and more effective ways to
accomplish the goal of cleaning the bank balance sheets.

Here’s how it works

A major part of the plan works as follows. One or more
giant investment funds will be created to buy up toxic assets from the
commercial banks. The investment funds will have the following balance sheet.
For every $1 of toxic assets that they buy from the banks, the FDIC will lend up
to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will
each put in 7.15 cents in equity to cover the remaining balance. The Federal
Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if
the toxic assets purchased by private investors fall in value below the amount
of the FDIC loans, the investment funds will default on the loans, and the FDIC
will end up holding the toxic assets.

Taxpayer giveaway explained with a numerical
example

To understand the essence of the giveaway to bank
shareholders, it's useful to use a numerical illustration. Consider a portfolio
of toxic assets with a face value of $1 trillion. Assume that these assets have
a 20 percent chance of paying out their full face value ($1 trillion) and an 80
percent chance of paying out only $200 billion. The market value of these assets
is given by their expected payout, which is 20 percent of $1 trillion plus 80
percent of $200 billion, which sums to $360 billion. The assets therefore
currently trade at 36 percent of face value.

Investment funds will bid for these assets. It might seem
at first that the investment funds would bid $360 billion for these toxic
assets, but this is not correct. The investors will bid substantially more than
$360 billion because of the massive subsidy implicit in the FDIC loan. The FDIC
is giving a "heads you win, tails the taxpayer loses" offer to the private
investors.

Specifically, the FDIC is lending money at a low interest
rate and on a non-recourse basis even though the FDIC is likely to experience a
massive default on its loans to the investment funds. The FDIC subsidy shows up
as a bid price for the toxic assets that is far above $360 billion. In essence,
the FDIC is transferring hundreds of billions of dollars of taxpayer wealth to
the banks.

Back of envelope calculation: $276 billion

With a little arithmetic, we can calculate the size of that
transfer. In this scenario, the private investors (who manage the investment
fund) will actually be willing to bid $636 billion for the $360 billion of real
market value of the toxic assets, in effect transferring excess $276 billion
from the FDIC (taxpayers) to the bank shareholders! Here's why.

Under the rule of the Geithner-Summers Plan, the investors
and the TARP each put in 7.15 percent of the purchase price of $636 billion,
equal to $45 billion. The FDIC will loan $546 billion. (All numbers are
rounded). If the toxic assets actually pay out the full $1 trillion, there will
be a profit of $454 billion, equal to $1 trillion payout minus the repayment of
the FDIC loan of $546 billion. The private investors and the TARP will each get
half of the profit, or $227 billion.

Since this outcome occurs only 20 percent of the time, the
expected profits to the private investors are 20 percent of $227 billion, or $45
billion, exactly what they invested. Similarly, the TARP's expected profits are
also equal to the TARP investment of $45 billion. Thus, both the TARP and the
private investors break even. As competitive bidders, they have bid the maximum
price that allows them to break even.

The bank shareholders, however, come out $276 billion ahead
of the game, while the FDIC bears $276 billion in expected losses! This transfer
occurs because the investment fund defaults on the FDIC loan when the toxic
assets in fact pay only $200 billion, an outcome that occurs 80 percent of the
time. When that happens, the investment fund is "underwater" (holding more in
FDIC debt than in payouts on the toxic assets). The investment fund then
defaults on its debt to the FDIC. The FDIC gets $200 billion instead of
repayment of $546 billion, for a net loss of $346 billion. Since this outcome
occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent
of $346 billion, or $276 billion. This is exactly equal to the overpayment to
the banks in the first place.

You know it’s a bank shareholder bailout when
…

Soaring bank stock prices during the last week, and then
again on the day of the announcement, demonstrate the bailout in action. From
March 9 to March 20, the KBW bank index rose by 33 percent, while the overall
Dow Industrials rose by only 11 percent, indicating how the rumors were
especially good for the banks. This morning, bank shares across the board soared
in value. Citibank has tripled in value since its low in early March. The value
of the bailout dwarfs the AIG and Merrill bonuses, but since the bailout is much
less obvious than the bonuses, the public's reactions have been muted, at least
at the start.

A better plan

The plan should not go forward on such unfair terms. Under
the law, Congress should apply the Federal Credit Reform Act of 1990, which
requires budget appropriations to cover expected losses on government loans
programs, which would presumably include the expected losses on FDIC and
Treasury loans under the Geithner-Summers Plan. With proper credit accounting,
the entire operation in our little illustration would require a budget
appropriation of $276 billion, equal to the expected losses of the FDIC and
Treasury. If the Administration goes to Congress for such an appropriation it
will be shot out of the water. The public will not accept overpaying for the
toxic assets at taxpayers' expense. Thus, it is very likely that the
Administration will attempt to avoid Congressional oversight of the plan, and to
count on confusion and the evident "good news" of soaring stock market prices to
justify their actions.

The Geithner-Summers plans for the FDIC are not the only
off-budget transfers to bank shareholders taking place. Other parts of the plan
support subsidized loans from the Treasury and, even more, from the Fed. The Fed
is already buying up hundreds of billions of dollars of toxic assets with little
if any oversight or offsetting appropriations. Since the Federal Reserve profits
and losses eventually show up on the budget, the Fed's purchases of toxic assets
also should fall under the Federal Credit Reform Act and should be explicitly
budgeted.

There are countless preferable and more transparent courses
of action. The toxic assets could be sold at market prices, not inflated prices,
making the bank shareholders bear the costs of the losses of the toxic assets.
If the banks then need more capital, the government could invest directly into
bank shares. This would bail out the banking system without bailing out the bank
shareholders. The process would be much fairer, less costly, and more
transparent to the taxpayer.

Take insolvent banks into receivership
instead: a bailout needs a workout plan

Banks that are already insolvent should be intervened
directly by the FDIC, that is temporarily taken into receivership. The
shareholder value would be wiped out, except perhaps for some residual claims in
the event that the toxic assets vastly outperform their current market
expectations.

As I've written before, the allocation of bank shares between the taxpayers
and the current bank shareholders could be make contingent on the eventual value
of the toxic assets, ensuring fairness between the shareholders and the
taxpayers.

Why are we bailing out foreigners?, by Andrew Leonard: Why did American
taxpayer money help AIG pay its debt to foreign counterparties?
Representatives from both parties raised the question during Tuesday's House
Financial Services committee hearing on AIG. On the surface, the question seems
perfectly reasonable. Why are American taxpayers bailing out foreign companies?
Shouldn't their own governments be taking responsibility for their welfare? ...

Few people seem inclined to accept that as far as the global financial system
is concerned, there's really not that much difference between foreign and
domestic financial institutions -- the web of interconnections tying all the big
players together is so tangled and intricate that if one link in the chain goes
down, everyone stands a chance of collapsing. (And yes, that's a bug, not a
feature.) If the goal is preventing systemic collapse, then everybody gets
bailed out, regardless of jurisdiction. But Bernanke followed up an answer along
those lines with an even more effective riposte: Hey, Europe has been bailing us
out too!

BERNANKE: ...The critical issue was, was AIG going to default and create
enormous chaos in the financial markets, or was it going to meet all of its
obligations, including those to foreign counterparties?

I would point out that the Europeans have also saved a number of major
financial institutions. And the issue of whether those institutions owed
American companies money has not come up. So I think that there is a sense that
we all have the obligation to address the problems of companies in our own
jurisdictions.

In particular, the Europeans could appropriately point out that it was under
U.S. regulation or lack of regulation and U.S. law that AIG failed. And in their
sense, we do bear some responsibility.

Good answer. ... All in all, I thought Ben Bernanke had a pretty good day on
Monday -- he's clearly gotten more comfortable dealing with rampant
Congressional irrationality over the last two years. ... And when he claimed
that after learning of the AIG bonuses
he wanted to file suit to stop the payments, he sounded believable.

This is another case (DeLong response) where having procedures worked out in advance can help
with both the politics and the economics. It's best if we don't have to waste
time bickering over who should pay for what while the economies of both
countries are going down in flames, and policies made in the heat of the moment
aren't always the best policies, particularly when they are made in combative
political environments. But all of that can be avoided if the polices are
thought through carefully and dispassionately in advance, and have the approval
of the appropriate authorities.

Sach Mukherjee disagrees with my mild support of the Geithner plan. He's
worried that if we let this window of opportunity for reform go by without
making major changes - and going with the Geithner plan is, he believes, a step
in that direction - then we are headed for an even bigger disaster than we have
now at some point in the future:

How will policymakers be able to tell if the plan is working? The first thing
to watch for is whether private money is moving off the sidelines and
participating in the program to the degree necessary to solve the problem. If
the free insurance against downside risk that comes with the non-recourse loans
the government is offering doesn’t induce sufficient private sector
participation, then it will be time to end the Geithner bank bailout. Even if
increasing the insurance giveaway would help, legislative approval would be
unlikely and the political fight that would ensue would hurt the chances for
nationalization.

The second factor to watch is the percentage of bad loans the government
makes as part of the program. These non-recourse loans are the source of the
free insurance against downside risk. Borrowers can walk away if there are large
losses, and if the number of bad loans is unacceptably high (a potential
political nightmare), then policymakers will need to act quickly and pull the
plug on the program.

Unfortunately, however, the loan terms make it unlikely that we’ll have
timely information on the percentage of bad loans. But there is something else
we can watch to assess the health of the loans: the price of the toxic assets
purchased with the loans. If the price of these assets is increasing
sufficiently fast, then the loans will be safe. But if the prices do not respond
to the program, then the loans will be in trouble.

In that case, we will need to end the program as quickly as possible and
minimize losses. The next step will have to be bank nationalization, though the
political climate will be difficult. Sticking with the plan until it completely
crashes and burns on the hope that a little more time is all that is needed will
make nationalization much more difficult.

There were three plans to choose from: the original Paulson plan in which the
government buys bad paper directly, the Geithner plan in which the government
gives investors loans and absorbs some of the downside risk in order to induce
private sector participation, and outright nationalization.

So which plan is best? Any plan that does two things -- removes toxic assets
from balance sheets and recapitalizes banks in a politically acceptable manner --
has a chance of working. The Paulson plan does this if the government overpays
for the assets, but the politics of that are horrible (as they should be). The
Geithner plan also has the two necessary features, though it has a "lead the
(private sector) horse to water and hope it will drink" element to it that
infuses uncertainty into the plan. This option also comes with its own set of political
problems -- problems that will worsen if the loans to private sector "partners" turn
out to be as bad as some fear. Finally, the plan for nationalization also includes these two
features, but it suffers from the political handicap of appearing (to some) to
be "socialist," and there are arguments that the Geithner plan
provides better economic incentives (though not everyone agrees with this
assertion).

I am not wedded to a particular plan. Each has its good and bad points.
Sure, some seem better than others, but none is so off the mark that I am
filled with despair because we are following a particular course of action.

Thus, I am willing to get behind this plan and to try to make it work. It
wasn't my first choice; I still think nationalization is better overall. But
trying to change the plan now would delay the rescue for too long, and more
delay is not something we dare risk at this point.

One of Simon Johnson’s points is very much worth emphasizing. When this
crisis hit, we did not have the procedures in place for an orderly resolution
for banks that were failing. Thus, because there were no well known procedures
to follow, the actions that the government took when faced with a failing bank
appeared ad hoc, almost random, because they were constructed on the fly to deal
with problems at individual banks.

The first thing we need to do is to change the regulatory structure so that
banks cannot get too big and too interconnected to fail. When they are too big,
their failure puts policymakers and the public in a position where there is no
resolution that can confine the costs to those who were responsible for the
problem. The dynamic is bad both ways: If the bank is allowed to fail, people
who did nothing to cause the crisis are hurt. But if the bank is saved the
people responsible are let off the hook at taxpayer expense, at least to some
degree, and that brings up issues of both moral hazard and equity.

But despite our best efforts, banks may become too large or too
interconnected anyway, particularly if the interconnections are not transparent
until trouble hits, and that’s where we need to do much, much better than we did
in the present crisis. We need to have procedures available to resolve problems
that are backed with a credible enforcement threat so that everyone understands
in advance exactly what will happen to institutions that are deemed insolvent.
We simply cannot repeat the uncertainty generating ad hoc, case by case approach
that was used in the present case.

Fed Treasury Accord, by Tim Duy: The Fed and Treasury released a joint statement yesterday afternoon that was lost amid the official release of the Geithner Plan (hat tip Across the Curve).
Clearly, it reveals the concerns of the Federal Reserve that its
expansive role in the crisis will eventually threaten monetary
independence, and thus wants that right/privilege reasserted:

The Federal Reserve's independence with regard to monetary policy is
critical for ensuring that monetary policy decisions are made with
regard only to the long-term economic welfare of the nation.

The need for such a statement was heightened by last week's FOMC
decision to expand the balance sheet via outright purchases of Treasury
securities (in addition to mortgage backed securities). Considering
the massive amount of red ink fiscal authorities are expected to spill
for the foreseeable future, the Fed's action could be interpreted as
the first salvo in a campaign to monetize deficit spending. I do not
believe that this is the interpretation the Fed intends. Indeed, I
believe this is one reason the Fed has shied away from the term
"quantitative easing." Note Bernanke & Co. always place the
expansion of the balance sheet in terms of the improving the
functioning of private capital markets. See Federal Reserve Chairman
Ben Bernanke's speech last Friday:

These purchases are intended to improve conditions in private credit
markets. In particular, they are helping to reduce the interest rates
that the GSEs require on the mortgages that they purchase or
securitize, thereby lowering the rate at which lenders, including
community banks, can fund new mortgages.

The stated intent is not supporting fiscal stimulus, creating
inflationary expectations, nor even fighting deflation. The Fed
expects they will withdraw their extraordinary liquidity operations
when financial conditions stabilize (see Monday's Wall Street Journal).
They expect they will have the political freedom to do so; but the
deeper they delve into financial markets, the more politicized their
activities become.

So I am not wedded to a particular plan, I think they all have good and bad
points, and that (with the proper tweaks) each could work. Sure, some seem
better than others, but none — to me — is so off the mark that I am filled with
despair because we are following a particular course of action.

Unfortunately, I have a darker temperament, a spirit less generous and
optimistic than Mark's. I am filled with despair, not because what we are doing
cannot "work", but because it is too unjust. This is not my country.

The news of today is the Geithner plan. I think this plan might work very
well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheet is a lie and
misdirection.

I can't say I agree with every word of this, but given what just happened to the economy and our general failure to see the signs that it was coming, it's a good time to hear alternative viewpoints about the state of the discipline:

The most important thing that global financial crisis has done for
economic theory is to show that neoclassical economics is not merely wrong, but
dangerous, by Steven Keen: Neoclassical economics contributed directly
to this crisis by promoting a faith in the innate stability of a market economy,
in a manner which in fact increased the tendency to instability of the financial
system. With its false belief that all instability in the system can be traced
to interventions in the market, rather than the market itself, it championed the
deregulation of finance and a dramatic increase in income inequality. Its
equilibrium vision of the functioning of finance markets led to the development
of the very financial products that are now threatening the continued existence
of capitalism itself.

Simultaneously it distracted economists from the obvious signs of an
impending crisis—the asset market bubbles, and above all the rising private debt
that was financing them. Paradoxically, as capitalism’s “perfect storm”
approached, neoclassical macroeconomists were absorbed in smug
self-congratulation over their apparent success in taming inflation and the
trade cycle, in what they termed “The Great Moderation”... [...continue
reading...]

Monday, March 23, 2009

Who Can At Least Tolerate the Geithner Plan?, by James Surowiecki: Most of
what’s been written about Tim Geithner’s plan ... has been, unsurprisingly,
negative, since Geithner’s plan does not involve the preferred solution of most
bloggers and pundits: nationalizing the banks. But there are some interesting
exceptions. The most useful post in terms of understanding the thinking behind
the plan is Brad DeLong’s
FAQ.
... And Mark Thoma of Economist’s View, who is actually an advocate of
nationalization, has nonetheless written two
excellent
posts explaining why there are problems in the market for toxic assets and
why the Geithner plan, while not ideal, could work in solving them.

Thoma’s conclusion to his second post, which comes after his analysis of
three options for dealing with the banking system (the original Paulson plan,
nationalization, and now the Geithner plan) is especially interesting:

... I prefer nationalization because it provides a certainty in terms of what
will happen that the other plans do not provide, the Geithner plan in
particular, but it also appears to suffer from the political handicap of
appearing (to some) to be "socialist," and there are arguments that the Geithner
plan provides better economic incentives than nationalization (though
not everyone agrees with this assertion). The Geithner plan also has its
political problems, problems that will get much worse if the loans that are part
of the proposal turn out to be bad as some, but not all, fear.
...
I am willing to get behind this plan and to try to make it work. It wasn't my
first choice, I still think nationalization is better overall, but I am not one
who believes the Geithner plan cannot possibly work. Trying to change it now
would delay the plan for too long and more delay is absolutely the wrong step to
take. There's still time for minor changes to improve the program as we go
along, and it will be important to implement mid course corrections, but like it
or not this is the plan we are going with and the important thing now is to do
the best that we can to try and make it work.

I tend to agree with Mark on this. The Geithner plan is suboptimal, but it is
probably the best we can get in the current environment. I'd add a
caveat: this plan is easy for the banks to game or arb - and if a bank is caught
gaming this plan, the AIG bonus flap will seem like a light Summer breeze.

Thoma concludes with the important point that even if a government intervention
loses the taxpayer money on the toxic assets themselves, it may still in a
broader sense be a good strategy, once we account in our risk function for the
high probability of very severe economic disruption absent any intervention.

Suppose we agree, on these grounds, that some intervention is better than no
intervention, even if it loses the taxpayer money in the narrow sense of a book
loss on the toxic assets. The question then shifts to which of the plans on
offer is best (or least bad)?